Credit markets: Volatility and spreads to remain elevated.
Corporate bonds performed poorly in 2015 as both investment-grade and high-yield bond indexes posted losses. Other fixed-income classes such as U.S. Treasuries and sovereign debt performed slightly better and generated positive returns; however, between the slight rise in interest rates and already low yields across the fixed-income universe, returns in those asset classes were subdued. The total return for 2015 of the Morningstar Corporate Bond Index (our proxy for the investment-grade bond market) was a loss of 0.46%; in the high-yield market, the Bank of America Merrill Lynch High Yield Index declined 4.64%. Losses were driven by a combination of rising underlying interest rates and widening credit spreads. In the investment-grade market, the average credit spread of our index widened 28 basis points to end the year at +168 basis points over Treasuries. The average credit spread in the high-yield index widened 191 basis points and ended the year at a spread of +695 basis points over Treasuries.
The energy and metals and mining sectors were hit especially hard as oil and commodity prices were decimated last year. For example, in the high-yield bond index, the average spread of the energy sector widened almost 660 basis points to +1,415 basis points and the average spread of the metals and mining sector widened about 650 basis points to almost +1,500 basis points. The average bond price in the energy sector fell 23 points to approximately 65, and in the metals and mining sector, the average bond price fell 24 points to a little under 62.
As commodity prices have fallen to multiyear lows, bankruptcy risk in sectors leveraged to raw materials has increased substantially and the credit ratings on those firms have been slashed. In addition, analysts have been sharply ratcheting down their estimates of recovery values. Between heightened near-term bankruptcy risk and lower recovery values, bond prices in the energy and metals and mining sectors dropped precipitously. Declines in these two sectors have had an oversize impact on the high-yield index as these two sectors account for a significant percentage of the overall index. Even after the high-yield energy sector lost over 23% in 2015, it remains the single-largest sector in the index, constituting more than 11% of the total.
The reason that bond prices have sunk further in the past few weeks is twofold: oil and commodity prices resumed their downward slide, and buyers are particularly wary. Distressed-debt investors had been waiting patiently for the past few years for the distressed-debt market to return in order to ply their expertise. Unfortunately for many of these investors, they began to put money to work earlier in 2015, only to see commodity prices continue to sink. Losses mounted in the first half of the year but were manageable. Oil prices staged a dead-cat bounce in late September/early October, which suckered many of these investors into doubling down on their positions. This led to a brief rally; however, as oil prices resumed their slide in early November, many investors looked to quickly exit positions and new buyers were nowhere to be found. In some cases, distressed-debt buyers have suffered 20%-plus losses this year. Currently, there is a gap in the market as those distressed-debt investors that bought bonds earlier in 2015 and experienced large losses either are too gun shy to increase exposure or lack the capital to do so.
Similar to the high-yield corporate bond market, the leveraged-loan market has also been experiencing similar price moves. For issuers whose financial results have been stable, the prices on their bank loans have held steady near par. On the other hand, at the first sign of any individual corporate weakness, prices for those issuers' bank loans have experienced air gaps on the way down. There are two dynamics that have led to the price gaps. First, the banks are stuck with a couple of hung bridge deals. As is typical of when the credit market overheats, the banks became overly aggressive structuring committed financing for leveraged buyouts and are now stuck with this paper until they can discount it enough to sell it. Second, the trading dynamics of the market have been changing and are currently much more difficult for investors looking to sell paper of deteriorating issuers.
A senior executive at a collateralized loan obligation asset manager explained that the constituent of investors in the leveraged-loan space has evolved since the credit crisis. Unlike in the past, currently there are very few buyers of leveraged loans priced in the mid-80s to mid-90s. When an issuer starts to suffer any kind of credit deterioration, this results in a large air gap on the way down. CLOs don't want to touch the paper, as potential downgrades of deteriorating companies will impair their weighted average rating factor scores, and banks don't want to undertake the capital charge to buy it for their own balance sheets. Often times, loans will gap down 15-plus points until distressed-debt buyers get interested (that is, a loan trading at 97 will gap down to the low 80s). Previously, a few points' move in the leveraged-loan market was a big deal. In addition to the problems in the energy and metals and mining sectors, the CLO asset manager executive mentioned that the media sector and, more recently, the pharmaceutical sector (especially after the Valeant debacle) were experiencing financial difficulties.
While widening credit spreads were the main culprit that led to losses in the corporate bond market, rising interest rates also pressured bond prices. Over the course of 2015, interest rates rose as investors priced in the beginning of the next monetary policy tightening cycle. The belly of the yield curve flattened as the market priced in the rise in the federal funds rate. Yields rose the most in the short term, held relatively steady in the intermediate range, and widened in the very long term. The 2-year Treasury bond rose 38 basis points to end the year at 1.05%, whereas the yield on the 5-year Treasury bond only rose 11 basis points to 1.76% and the 10-year bond rose 10 basis points to 2.27%. The yield on the 30-year bond rose 27 basis points to 3.02%.
Credit Markets: Volatility and Spreads to Remain Elevated Following is an updated synopsis of our credit market outlook for the first quarter of 2016, originally published Dec. 28, 2015, by Rick Tauber, director of corporate bond research.
Headwinds including mergers and acquisitions, weak commodity prices, and Fed tightening should keep spreads at elevated levels. We expect volatility to remain elevated in the first quarter, with credit spreads staying range-bound at or near their recent levels. We expect the ongoing headwinds of weak commodity prices and debt-funded acquisitions to continue. Pressure on the energy and metals and mining sectors, which were hit hard in the fourth quarter, do not look likely to abate in the near term, per our sector analysts. Still, we expect moderate domestic economic growth to continue, which along with spreads at above-average levels should provide support to valuations.
We view the current investment-grade market as fair to slightly overvalued, given weaker credit quality and poor technical conditions. The investment-grade market has been negatively affected in 2015 by a number of factors including record M&A activity, falling commodity prices, and shareholder activism. With revenue growth either stagnant or declining and operating margins under pressure, companies have looked to other sources to boost growth and value, including massive share-repurchase programs. This led to record new bond issuance in 2015, which has also contributed to spread widening over the course of the year.
As of Dec. 31, 2015, the average spread of the Morningstar Corporate Bond Index was +168 basis points over Treasuries, which is 28 basis points wider than the level at the end of 2014 and slightly wider than the long-term average of the index (excluding the financial crisis) of +160 bps. Spreads are also well wide of the recent tights of +101 bps in July 2014. The average spread of the investment-grade index is currently about +20 bps inside of the widest level it recorded earlier in 2015 of +188 bps, reached Sept. 30; the average credit spread in the high-yield market remains near its widest levels. This is partially due to the composition of the investment-grade index compared with the high-yield index. The investment-grade index comprises a significantly lower percentage of bonds in the energy or metals and mining sectors and a greater amount of bonds in the financial sector. Bonds in the financial sector have held up relatively well this year and have widened less than half as much as the overall index.
In 2016, we expect M&A to taper off from the record levels in 2015, which could eventually ease the new issue supply burden on the investment-grade market. However, new issue supply from deals announced but not yet funded remains substantial and could put pressure on spreads in the first quarter. We also expect fourth-quarter earnings results to be largely mixed, given the confluence of global economic weakness and pressure from declining prices in the commodity sectors. Management guidance for 2016 revenue and earnings has the potential to disappoint, in our view. Finally, our list of ratings under review with negative implications (UR-) far exceeds our list of ratings under review with positive implications (UR+), and our downgrade/upgrade ratio remains heavily slanted to recent downgrades, suggesting that credit quality is weakening. As such, we see spreads as most likely to be range-bound, with widening back out to the 2015 highs as possible.
We view the high-yield market as fairly valued to slightly expensive near current levels, as we see the market pricing in a substantial increase in defaults from the energy and metals and mining sectors. High-yield spreads, as measured by the Bank of America Merrill Lynch High Yield Master II Index, reached +683 basis points over Treasuries on Oct. 2, tightened over 100 bps a month later, and then rose to a new high of +733 bps on Dec. 14 before settling back to +695 bps on Dec. 31. Yields are also near their widest levels of the year at 8.76%, driven by ongoing weakness in the energy and metals and mining sectors. We see the high-yield market as remaining bifurcated, with some of the more consumer-oriented sectors trading at low but sustainable yields and some of the commodity or industrial sectors trading at yields that are well wide of the index. For example, the food, beverage, and tobacco sector of the index yields just over 6% despite an average rating of high single B. The energy sector yields almost 15% despite a similar high single B average rating.
The latter will also eventually suffer elevated defaults, and we expect overall market default rates to increase well above the 2%-3% range we have seen, although probably not in the first quarter. As such, high-yield performance will continue to be driven by sector selection, and we lean toward more conservative sectors. The bulk of our best ideas have been higher-rated credits throughout the year. We also worry about the recent trends of sharp fund outflows combined with poor liquidity leading to gap downs in bond pricing. This has mostly permeated the weaker sectors, but if fund managers are forced to look to higher-quality names to raise cash, this could add pressure to the whole market.
Supportive of credit quality is the economic outlook provided by Robert Johnson, director of economic analysis. He continues to forecast that real GDP will expand between 2.0% to 2.5% in 2016, similar to the level that he accurately predicted over the past several quarters. Positive slow economic growth despite global headwinds, a gradually improving jobs story, and a boost to consumers from lower commodity prices can all be supportive of corporate credit.
Potentially complicating the outlook is the fact that we are at the front end of the first Federal Reserve tightening schedule since 2006. With much of the rest of the world easing or providing artificial support to markets, this could result in ongoing support to the dollar but stunt revenue and operating income at global U.S. companies. Still, we see the Fed's approach as likely to be very methodical, with strategic rate hikes over an extended period, assuming the economy holds up. Initially we don't believe this will have a meaningful impact on the important two thirds of the economy that remains in growth mode, the consumer. We don't expect any Fed moves to substantially drive intermediate- or long-term interest rates higher, although that remains a risk as investors could move to the sidelines on corporate bonds similar to when the taper tantrum occurred in 2013.